AAA Debt Rating: What Would Life Be Like Without it?

We are mere days away from the August 2 deadline for the U.S. Congress to pass legislation providing the federal government with an increase in the debt ceiling.

At the time of writing, the political jousting between Republicans and Democrats has continued with the latest round coming from back-to-back televised pleas from President Obama and House Speaker John Boehner. For a number of reasons this was always going to play right down to the 11th hour, which is why we don't look out of the window and see financial markets in an absolute panic.

Many Congressional representatives are new to politics and are seeing this more as a perfect ideological battle versus a pragmatic exercise in balancing fiscal and economic objectives. Republicans have also seen this as an opportunity to force a bad result in the hopes that it tars the Democrats going into the 2012 presidential election.

The risk, of course, is that opposing a White House-backed compromise package would be viewed as reckless, especially if the economy turns sour as a result. Sure enough, the latest polls indicate that close to half of Americans support a compromise fiscal package and do not believe politicians would let this situation unravel to the point where a government shut-down occurs, and the U.S. defaults on its debt obligations.

Since the popular press has done a good job in linking the Aug. 2 deadline with the future of the U.S. credit rating, many Americans believe that getting a debt authorization increase by this date will protect the coveted AAA rating that the U.S. has enjoyed for many years.

That would be naïve. At the end of the day there is nothing sacred about that AAA stamp on Washington IOUs. The U.S. has the enviable position of being a reserve currency nation and the bond market of choice for so-called 'risk-free' assets. As such, there has always been the notion that there was almost zero risk of default on debt servicing or redemption on maturing issues given that the U.S. had a virtual monopoly on demand for its bonds and could ramp up the cash printing presses to help pay its interest and maturities.

When the debt ceiling was well below $10 trillion, this notion was an easy one to count on. Now, with the ceiling poised to increase beyond $16 trillion, the wonders of compounding are kicking in.

It's not just that ratings agencies are concerned about debt payments not being made after Aug. 2, if a new ceiling is not approved; it's that failure to put the U.S. on a positive trajectory in reducing its deficit will make yet further ceiling increases necessary -- and sooner. What Americans and global investors need to keep in mind is that failure to turn these trillion dollar-plus deficits around in a reasonable amount of time will establish a structural component to the deficit that cannot be escaped without drastic measures.

Using the UK and Greece as examples, drastic measures will be significant hikes in taxes and draconian spending cuts -- both of which will work against the economy.

Let's assume that a new debt ceiling is approved by Aug. 2, but that ratings agencies are still not happy with the progress on the U.S. deficit. In other words, let's pretend that the AAA rating disappears. There are two effects that investors are focused on -- a sell-off in the bond market and continued rout of the U.S. dollar. Of these, I would suggest spending more time worrying about the latter and less timing getting worked up over higher rates.

True, any time a country or company gets its rating chopped, the cost of borrowing in the market usually goes up; however, estimates suggest that the back-up in U.S. bond yields would be in the order of about a percent or less. In the case of the 10-year Treasury note, this would imply a move back up to about four per cent or maybe even 4.5 per cent. Under those scenarios, bond holders would experience an eight or 11 per cent capital loss, respectively. Not a pretty development, but not the end of the world either.

Mortgage rates would move higher, which would slow the U.S. housing market down, although it is unclear whether this would be sufficient to actually tank home sales and prices. Case in point, the 10-year yield rose from 2.4 per cent to 3.6 per cent from October to February and all we got was a reversal of less than half of the 2010 advance in U.S. existing home sales.

No, if you're Canadian the dollar risk is greater. Even the prospect of a modest correction in U.S. bond prices could influence foreign debt holders to unload paper, causing not only bond prices to dip but the U.S. dollar to fall as well. This could snap the greenback out of its recent consolidation pattern and cause a resumed slide to new record lows against many developed currencies, including the Loonie.

If one wants a scenario where the Canadian dollar extends above US$1.10 and stays there, a U.S. rating downgrade could easily be the ticket. Opinions vary as to where the real threshold of pain is for Canadian manufacturers and exporters, given that many companies have adjusted to the new 'parity' environment. Suffice to say the threshold isn't that far above US$1.10.